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Seed Weekly - Property Prejudice

I recently had an enquiry from a client who is part of an “investment club”. This club only invests in Commercial/Industrial Property and are all currently held in one geographic area. The question from my client was twofold and I will be dealing with the two separate issues in two articles.

The first question was, “Is it wise to only invest in Commercial/Industrial Property, should we be looking at other investments?” The second question was, “There is large cash build up in the business whilst we are looking for properties to purchase, the time horizon for this cash build up if often in excess of a year, is there a more effective way of saving cash than a bank account?”

When dealing with the first question we need to look at the advantages and disadvantages of holding Commercial/Industrial properties and then compare them to other asset classes and to general investment theory.

A main advantage of owning properties is your income stream is generally inflation proofed through the rental escalation mechanism. Over time you also usually have escalations in the capital value of the property. From an investment psychology perspective, one of the major advantages of holding property is that the price/value of the property is not quoted in the newspapers everyday so the investor is not seeing constant volatility in the “value” of their investment. Because of the fact that most people are optimists, the fact that our neighbour sold his property for less than we purchased ours for does not usually concern us. Property growth rates also often have a low correlation to equity markets.

We frequently hear in the investment world there are no free lunches, so what are the risks of holding these properties?

The first risk is tenant risk. As the owner of a property, we first have to find a tenant, the tenant needs to pay us timeously, and we then need to hope that he doesn’t cause damage to the property and disappear. The next risk is liquidity. In order to sell the asset there needs to be a willing buyer. If the economic circumstances are not great, unpleasant neighbours move in, or there is an oversupply of property you suddenly you can’t sell the asset for what you think it’s worth. In really bad circumstances you can battle to give it away! Geographic risk is also something that needs to be taken into account when buying a property. I remember how property owners struggled to rent/sell anything in Carletonville when the gold mines closed down, and I would imagine that the platinum strike in Rustenburg is having a huge impact on the property market. If a number of mines close down because of the strike property values could de-rate permanently. The last risk that I want to look at with Property is diversification. Because of the large investment that needs to be made per unit, diversification of your risk is difficult.

Diversification is the easiest way to achieve an improved risk adjusted return. When we look at diversification in general, we generally look at diversification across asset classes (equity, listed property, bonds, cash, and alternative investments). We also look at geographic diversification where we try and spread our investments over a number of different countries. Finally, we diversify across fund managers with different investment styles, approaches and philosophies.

When looking at investment portfolios you should always try to achieve a balance between owning your own properties, listed properties, shares, bonds, cash, and alternative investments in various geographic locations. Commercial/Industrial Property can therefore form part of your portfolio, but it is wise to spread your investments. Because of the risks involved, owning your own properties should give higher returns than a diversified investment portfolio. It needs to be borne in mind, however, that when it goes wrong in property it often goes very badly wrong, with very large losses being caused by unforeseen events.

Seed Weekly - African Equity in a Multi Asset Fund

Investing into Africa (for the purposes of this article, Africa refers to Africa ex South Africa) has become fairly popular over the past few years. As is often the case, investors are looking for ‘the next big thing’ and it seems that Africa currently can be classified as a candidate for ‘the next big thing’.

One of the reasons why investing into Africa has become popular for South African managers and investors is the change in legislation that allows Reg 28 funds (funds that can be used in retirement products) to invest an extra 5% into Africa on top of the maximum allowed 25% global allocation. With local markets expensive both on a nominal basis and when looking at various valuation metrics, many managers and investors are looking at where else they can expect to generate decent real returns.

When looking at returns generated from Africa equity it is important not to just look at the relative performance over a certain period. More important than the overall performance, is how it has performed relative to South African and Developed Market equities over various periods – essentially looking at the return profile.

An example of what this means is that while the average correlation of monthly returns between Africa equity and SA equity is 17% over the past 12 months on an annual basis it has been above 80% and as low as -80% as shown in the chart below.

When making an allocation we need to assess whether the correlation will fall back to its long term average of around 17% or lower (which is desirable) or if it will remain high as it has over the shorter term.

Assets that have a low (or negative) correlation that are blended with one another and regularly rebalanced gain the benefits of diversification. By blending the asset classes one is generally able to create a solution that either has a better return (with no extra risk) or lower risk (without sacrificing return) or ideally a combination of both when compared to the stand alone asset class. In the case of blending a typical balanced fund (95%) with Africa equity (5%) one has been able to slightly improve the return when compared to the balanced fund and also reduce the downside deviation over the past 12 years.

When a manager or investor is satisfied that the return profile going forward will be sufficiently uncorrelated the next step in the process is to ensure that the valuations are reasonable. It doesn’t make sense to allocate capital to a grossly overvalued asset (currently developed market bonds can be classed in this category) purely because of the diversification benefits that can be achieved. Each asset should only make its way into a portfolio if it offers the opportunity of positive returns. The valuation of Africa equity currently looks reasonable (especially when compared to SA equity).

Furthermore one needs to assess the relative merits of active and passive management, both in the current environment and in the specific asset class universe. At Seed our opinion is the opportunity offered by active managers in Africa equity (especially those that spend a great deal of time in the various countries) far outweighs the extra costs incurred. Over the past month and a half we have started to make small allocations to Africa equity across our multi asset Funds.

Seed Weekly - Active Share

Active share has emerged as a new metric to assess active managers. The metric focuses on how individual stock weights in a portfolio differ from the weights in a benchmark, providing an enhancement over traditional measures such as tracking error. Simply said, active share is the fund’s percentage that is different from its benchmark. By looking at the active share you can determine if the manager is doing active stock selection or secretly hugging the benchmark.

Active share is calculated by summing the absolute difference between a stocks weight in the portfolio and the index and then halving the value and ranges from 0% (100% overlap with benchmark) to 100% (zero overlap with benchmark).

The chart below shows the stock selection of two funds and the index (benchmark) weight of the stocks.

From the chart we can see that Fund 1 is much more active in stock selection and weighting compared to Fund 2. Fund 2 is an example of closet indexer or benchmark hugger. Practically, Fund 1 has an active share of 60% and Fund 2 has an active share of only 10%.

A closet indexer is an ‘active’ manager that only takes small relative positions when compared to the index that is used as the benchmark. The returns of these funds will, gross of fees, typically be similar to that of the benchmark, but below the benchmark after fees are deducted. These managers tend to shy away from making high conviction investments which would differentiate them too far from the benchmark.

Bank Credit Analyst (BCA) looked at the active share of all equity unit trusts in the US over the last 34 years. The funds were grouped into bands by active share. They discovered that, over time, there has been an increase in funds that are closet indexers.

To get returns different to the index, a fund needs to be positioned differently to the index. The research done by BCA showed funds that outperformed the index also had a high active share.

BCA also took a look at the relation between active share, fund size and outperformance. The chart below shows the relative performance of funds broken up into fund size and active share.

From the chart we can see that small active funds had, on average, the highest outperformance. The chart also interestingly shows that fund size doesn’t have a material impact on relative performance, but that active share is a more valuable measure of whether there will be outperformance. Naturally, as a fund gets larger it becomes more difficult to retain a high active share.

While active share is very useful, it is simply another tool that should be added to an investor's toolbox for use in evaluating investment portfolios (unit trusts, segregated accounts, pension funds, etc). As the research becomes more widespread we expect that more emphasis will be placed on active share, making it more accessible for the average investor. It is currently very difficult for the average investor to calculate active share for a range of local equity managers. The key take out is that funds that are closely aligned to an index will struggle to outperform after costs.

Due to the concentrated nature of the local market we expect that South African funds will have a lower active share when compared to global funds. Globally, active share should be above 80% for a fund to be considered ‘active’, locally we expect it to be above 70%. At Seed, when allocating client investment to an active manager, our preference is for an active share consistently in excess of 75%.

Seed Weekly - Starting Early

I was recently invited to speak at a corporate wellness day and one of the topics we discussed was how to secure a stable financial future from a young age. The most obvious point raised was that this doesn’t happen by itself or overnight and requires a long term disciplined approach. The second point we discussed was the benefit of starting early and the subsequent implication of investing from a later age.

To bring across the second point I resorted to a few graphs based on a fictional 30 year old person who has no investment assets and would like to be in a position to retire with (today’s equivalent of) R 30 000 a month at the age of 65. In order to reach this goal the person would need to have +- R 5.8m in discretionary assets at retirement in order to fund a ‘pension’ of R 30 000 per month, this amount is calculated by Seed’s Retirement Planning Tool that uses past returns to calculate possible future values of assets. It is important to note that the asset values are in real terms. In order to fund this liability of R 5.8m the person would realistically need to have investment assets of R 6.9m available. The next step is to find out how it would be possible to reach this target of R 6.9m in 35 years, the answer is simply to invest R 4 500 per month into a balanced portfolio of growth oriented assets and increasing this amount by inflation + 2% each year. To show how this paragraph above can very easily be plotted graphically refer to the below:

With such on long time to go before this person would retire we don’t assume to have one plan that can cover all eventualities, rather we would take the information at our disposal and put a plan in place that is to reviewed regularly.

The next and very important point we discussed was the issue of procrastination. To show the effects we went back to the previous person and asked what would happen if they waited 5 years before investing. If the goal of R 30 000 per month stays, the person would need to increase the contributions to R 6 000 per month with similar annual increases in order to reach a targeted asset base of +-R 6.5m. The same graph with the new assumptions is shown below:

At this point the discussion naturally went to the sometimes underestimated effect of compounding on your investment portfolio. The earlier you start investing the more likely it will be that compounding enhances the value of your portfolio. By taking the above 2 scenarios and plotting the cumulative investment values and growth on one graph it becomes very apparent that the earlier you start the more you stand to benefit.
The 1st graph is for the 30 year of and the second is for the 35 year old:

The orange portion of the graph is the growth achieved on the contributions and increases as the compounding effect becomes more pronounced over time. The orange part of the above graph is larger compared to the graph for the 35 year old investor.

At Seed we have a qualified team available for individual investment consultations whose aim it is to guide you through the process of setting financial goals and ensure that there is a plan in place to reach those goals. Based on the above analysis, and common knowledge, it pays not to procrastinate when beginning to save for retirement.